10 Questions to Ask Yourself Before Investing In The Stock Market
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If your investing career began after March 9, 2009, your returns have likely been amazing. This particular day is when the S&P 500 bottomed out during the Great Recession.
Investing may seem easy as there haven’t been many bad investments in the past decade. But you should always exercise prudence regardless of how well the market is performing. Before investing new cash, asking yourself a series of investing questions can be time well-spent.
I routinely ask the below questions before I consider buying individual stocks, index funds, or alternative assets like real estate or precious metals.
Do I Understand the Investment?
Blindly buying a someone’s “stock of the week” probably isn’t the best long-term investment strategy. While getting investing advice is a good idea but you should understand how the investment works before you buy a position.
If you don’t understand how an investment makes money or can lose money, avoid it until you can.
Gold mining stocks operate differently than a gold trust exchange traded fund (ETF) yet both let you invest in gold, for example.
You should understand simple offerings like index funds and target date funds in your 401(k) plan. For sure, you need to understand individual stocks and alternative asset classes.
Reading a fund prospectus, even for an index fund, is one way to learn about an investment. The prospectus tells you how the fund managers will invest your cash under normal and abnormal market conditions. This document also lists the various fund fees and manager details.
For individual stocks, read recent earnings call transcripts and 10-K forms. Also take the time and compare your potential buy to its competitors. Maybe you will find a better alternative.
Some of the key details you may look at include:
- Recent insider buys or sells
- Pending lawsuits or settlements
- Current levels of debt
- Is the company profitable? If not, can they become profitable?
- Potential short-term business challenges
- Ongoing company initiatives to remain competitive
- Is the company share price at the top or bottom of its historical range?
You can add your own questions to complete your research. The main intent of this exercise is to know about what’s in your portfolio.
Does This Investment Match My Risk Tolerance?
Headlines and other investment trends influence our investment strategy more than we let on. You need to make sure each new aligns with your risk tolerance.
For example, are you buying a technology stock because it’s outperforming the broad market in the moment or because it has the potential to be the next Microsoft?
As key interest rates hover near historic lows, you may also be more prone to chase higher yield. But higher yield usually means more risk. You may find yourself investing in junk bonds with a BB+ rating or lower. Or, you invest in dividend stocks when you should be favoring bonds.
The most aggressive investors may even feel attracted to leveraged ETFs to potentially double or triple your short-term earnings. Remember that a pendulum can swing two ways as market sentiment changes. You must be willing to give up your unrealized gains as quickly as you may earn them.
What are the Investment Fees?
It’s possible to pay several layers of fees depending on how you invest:
- Trading commissions
- Annual fund management fees
- Financial advisor fees
Trade commissions and ongoing fees can increase your investing costs. Fees are unavoidable to a certain extent as you can choose low-fee investments like index funds.
You will also need to decide if the fees are worth the potential annual return. For example, do you need to pay a financial advisor an annual 1.5% asset management fee when you can build a similar index fund portfolio? More effort is required by you, but you can free up some extra cash to invest.
Is the Investment Income Taxable?
Trade commissions and the fund expense ratio might be the only two fees you look at when trading. But you should also think about how often your investment income will be taxed.
Tax-advantaged 401(k), IRA accounts only require you to pay taxes once on your contributions. However, you may need to pay taxes yearly on any gains in a non-retirement account. Yet TFSA (Tax-free Savings account) allow you to withdraw tax-free.
The IRA contribution limit for 2022 is $6,000 ($7,000 if aged 50 or older) which is the same as a TFSA. A traditional IRA gives you an immediate tax deduction but a Roth lets you make penalty-free withdrawals in retirement.
It’s possible to reduce your tax bill with certain investments. A great example is a 1031 Exchange for rental property swaps. Some robo-advisors will do tax loss harvesting to minimize your capital gains tax.
Am I Trying to Time the Market?
Successful investing requires a multi-year commitment. Constantly moving in and out of positions limits your compound interest and increases your taxes and fees.
You can also become more skittish to reinvest your cash until a large correction comes. The only challenge is that you must be brave enough to buy quality assets when all your friends are selling. It’s not as easy to always be a confident investor as you think.
One habit of successful investors is to invest new cash on a regular basis. An easy way to develop a steady investing frequency is contributing a small amount of each paycheck. This strategy is called dollar cost averaging.
No matter what the market is doing, you invest the same amount each pay day. If buying individual stock, you might wait for the quarterly earnings to report to avoid a potential multi-percent swing.
Is My Portfolio Properly Allocated?
You should periodically make sure your investment portfolio remains properly allocated to reduce portfolio risk. Will this next investment make your portfolio unbalanced?
One reason why index funds are so popular is that it’s easy to balance your portfolio. For instance, a three-fund portfolio exposes you to nearly every U.S. and foreign market sector.
You should still maintain an age-appropriate stock to bond asset mix. Although reallocating a few funds can be easier than several dozen stocks and sector ETFs.
Can I Still Monitor Every Asset?
Your investment research doesn’t end when you execute a buy order. You should still review each position you own on a monthly basis. Some investors recommend spending one hour per month on each investment you own to look for any new red flags.
With the help of free portfolio management tools, it’s not difficult to monitor your assets across several brokerage accounts.
But, if you have more assets than you feel comfortable tracking, than you may want to rethink adding another piece to the puzzle.
Why Am I Buying Today?
Can you answer with confidence why you’re buying a particular asset today?
Consider keeping an investing journal to jot your reasons for each trade. You may easily forget the original reason you made a certain investment. Looking back at your journal can remind you of your original investment thesis. This is also an easy way to compare your projections to actual performance.
How Easily Can I Sell?
One of the worst investment outcomes is not being able to sell a losing investment you want to exit. You can see the market value continue to drop as you wait for a buyer.
Some investments are easier to sell than others due to the liquidity factor. Stocks and publicly-traded ETFs or mutual funds are highly liquid and can be sold any day the market is open.
Alternative asset classes like real estate, rare coins, or art can take months to sell. Some platforms may only let you sell on a quarterly basis. Imagine how quickly the market value can change as the sale finalizes.
You may also need to commit to owning a particular asset for several years. Crowdfund real estate, for instance, may need to be held for at least 5 years before you no longer pay an early redemption fee.
When Will I Sell?
Your exit strategy can be very important. Before buying any position, imagine what selling looks like. You might sell your original investment amount when it doubles but keep the gains invested. More importantly, you may use stop losses to limit your downside risk.
Asking these questions won’t result in risk-free investing. But it can make the research process less stressful. You can also be a more organized investor who can realize a good opportunity.
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